The fact that wealth is rapidly declining deserves public policy attention. Wealth serves critical functions in the U.S. economy that relies heavily on individual initiative. It is primarily an insurance against a range of economic risks. The more such insurance exists for the typical family, the less a family has to worry about their basic necessities and the more they can focus on longer-term economic growth. A family that has the basics covered can take more chances by sending their kids to college and letting them choose a degree that suits their abilities. Also, family members can more easily switch jobs to match their particular skills. And, a family with enough wealth is in a better position to let their creative side take hold and start a business. The entire economy wins from letting people gain more skills and apply those skills most effectively in their job or by starting a business.

Recommending what the government should and should not do about rebuilding family wealth has become as ubiquitous as real estate ads in the mid-2000s and dot-com IPO discussions in the late 1990s. Here are just a few principles that will likely guide the reform debate.

Here is another example from the list of “things that we saw coming, but nobody cared.” Credit card companies are suffering from record default rates. In the fourth quarter of 2008, credit card companies charged off – declared as uncollectible – a whopping 6.3 percent of their debt. Aside from a fluke spike in the data in the first quarter of 2002, this was the largest charge-off rate since the Federal Reserve began collecting these data in 1980.

Interestingly, these record setting losses for credit card lenders come after the punitive changes to the bankruptcy code were supposed to weed out the “deadbeat” borrowers and lead to lower default rates. Apparently, things did not work out as planned.

Ahh, retirement – so many possibilities, so little time! Turns out that for millions of Americans the dream of a secure retirement was just a dream. From 2007 to 2008, total retirement wealth in private and public sector pension plans and retirement savings plans dropped by $2.8 trillion (in 2008 dollars).

Not all retirement plans are created equal, though. Data from the Fed show that holding gains and losses – changes in asset values minus contributions – relative to initial asset values tend to be higher for traditional pension plans than for retirement savings plans, such as 401(k) plans. Holding gains are typically used as an approximation of rates of return for these data.

Here’s a news flash: The housing market is bad. Actually, it is really bad, historically, woefully bad. And, the bad news won’t stop coming. Housing wealth is dropping precipitously, families own ever smaller shares of their own homes, and home owners are falling behind in their mortgages in record numbers.

According to data from the Federal Reserve, housing wealth has taken a nose dive for two years. In December 2006, housing values reached a peak of $18.9 trillion (in 2008 dollars). By December 2008, they had fallen by $3.9 trillion to $15.1 trillion.

This reflects a historically fast depreciation of housing wealth. Over the past two years, real housing wealth dropped by 20.5%, a record for any two-year period since 1952. In fact, before this crisis occurred, there had never been a two-year period when real housing value fell by more than six percent.

A trillion here, a trillion there and all of a sudden you are talking real money. We are getting used to the “T” word. Over the past year and half – from the middle of 2007 through the end of 2008, when the crisis unfolded – the crisis in the housing market and in the stock market has cost American families a total of $15 trillion in 2008 dollars.

It makes sense, though, to put the loss of personal wealth in perspective. In these 18 months, approximately 27 million times the average family’s wealth -- $566,000 in 2008 dollars. Put differently, equivalent of the average family’s net worth disappeared every 1.8 seconds in those 18 months.

In fact, this was the sharpest relative wealth decline in more than fifty years. Over the 18 months since the crisis began, inflation-adjusted personal wealth has fallen by 22.8%. This was the fastest such decline since the Federal Reserve started to collect the information in 1952. The quickest 18-month wealth decline before this crisis was 12.0% for the period from March 1973 to September 1974. We are shattering speed records that nobody ever wanted to break.

Didn’t families build up enough of a buffer because of the bull market in the housing and the stock markets? Apparently not. Family wealth is a buffer for emergencies, insurance for when sources of income like wages disappear, e.g. because of retirement, and a tool to invest in one’s own future through education or starting a business. Hence, it is important to compare current wealth to current income. In the fourth quarter of 2008, the ratio of wealth to after-tax income stood at 483.3%, its lowest level since March 1995. It’s as if the stock market boom of the 1990s and the housing boom of the 2000s never happened.

At the end of the day, though, these declines matter because they leave families in a very precarious situation. Over the years, we have asked families to shoulder an ever greater economic burden. Health insurance coverage and the quality of health insurance have dropped, “do-it-yourself” savings plans have taken the place of traditional pensions, changes to financial aid and rapidly rising tuition costs have meant more and larger student loans, Social Security benefits have already been trimmed, and a whole host of social programs have been cut. Personal wealth today takes on a completely different meaning than it did for previous generations. The money that a family sets aside has to go a lot further than it used to. That’s why the trillions in lost wealth are especially scary.

With Wall Street in turmoil and the economy on a downward slope, policymakers' ingenuity to help financial markets and the economy is demanded. The response will have to be large, but also smart. Voters will likely not accept an approach that simply throws money at the problem, never mind that the government will eventually run into some hard times itself if policymakers think that more money will fix all that ails us. Undoubtedly, some tax cuts and some spending increases will have to be part of the solution, but given the recent financial rescue package and the need for a short-run money injection to avoid a major recession, policymakers will need to think smartly about other tools at their disposal to help the economy to recover.

The other day I listened to an ad, where a mortgage bank was arguing that, although mortgage interest rates have recently gone up, they are still relatively low at historical rates. Never mind the wisdom of fighting a crisis of too much leverage with more leverage, consumers hopefully have learned their lesson from the past few years that it matters if they can afford the mortgage payments in the future, not just in the first month. And, current economic data show that mortgage payments are probably less affordable now than at any point in the past four years.

You can't be serious! Federal Reserve chairman Ben Bernanke says what anybody with a passing interest in economics already knows -- that it will take time for the economy to turn the corner -- and the market tanks. The market seemed punch drunk on the massive stabilization packages -- $2.5 trillion and counting -- that the industrialized world was showering on failing financial institutions. A mere 36 hours later, though, Wall Street realized that it cannot regain its strength without a healthy Main Street. It was a weakening labor market, following a bursting housing bubble, that contributed to the massive foreclosure wave and to the crisis. No amount of tinkering with the stabilization package will detract from the fact that people and businesses need more income, not loans, to pay their bills and to invest in their future. It should be clear by now to everybody, even extremely myopic financial markets, that the next policy step lies in helping U.S. businesses and families back on their feet through a well designed second economic stimulus.

At this point, it is all too clear that financial markets can get things wrong. This is not an isolated phenomenon. No, getting it wrong tends to be the name of the game for financial markets. Understanding that financial markets regularly underestimate or overestimate the risks of investing is crucial to the proper design of financial market regulations.

Financial markets went into free fall in late September and early October. The third quarter of 2008 continued the wealth destruction that took place in the previous nine months. This wealth decline is large, broad, and quick.

The primary reason for wealth building is retirement. Many families nearing retirement, though, relied primarily on their homes for their retirement income. According to the Federal Reserve, only 62.9% of families between the ages of 55 and 64, had a retirement account, such as a 401(k) or IRA, in 2004. The typical holding in such accounts was $83,000 in 2004 dollars. In comparison, 79.1% of such families owned their own house with a total typical value of $200,000. In other words, policymakers need to take a comprehensive view at restoring family wealth in an effort to strengthen retirement income security. Much of the policy attention has been on protecting housing wealth. Policy responses, though, need to match the problem, specifically by fostering a pension renaissance and by vastly improving existing retirement savings plans in addition to protecting housing wealth.

The stock market just ended its worst week in history. This has sharply eroded families' financial security. Under rather optimistic expectations it would take about six years before families can hope to achieve the same level of financial security as they had at the end of 2007, before the latest round in the financial market crisis took shape.

There is a serious danger that the economy will fall into the dreaded "liquidity trap" -- no matter how cheap money is, companies and families will not borrow since they are too freaked out about the future. Worldwide financial rescue packages, central bank liquidity injections, and government equity stakes in private banks are all intended to provide the desperately needed liquidity. Now, it is important to get businesses and households to borrow this money. One important step in this effort will be for trusted spokespeople to calm the fears of businesses and families over their economic futures. If the recent past is any indication, we will need a different set of spokespeople for the econmoy, though, to accomplish this.

I wanted to thank Bob Lawless, Elizabeth Warren and Credit Slips to invite me back as guest blogger. It seems an appropriate time to discuss topics in two of my areas of expertise -- financial crises and retirement income security -- as they are directly related to the current financial turmoil.

The markets are crashing. This is a standard financial crisis, as many other countries experienced over the past twenty or so years. In a crisis four risks materialize: default risk, maturity risk, interest rate risk, and exchange rate risk. We are spared from the last one since the dollar dropped well before this crisis. The problem is that we are not adequately addressing the remaining risks.

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Bankr-L

As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information.
Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service,
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